Subtle shift signals 'profound change' in bank regulation

In the last 10 days, a series of major policy proposals from Britain’s banking
regulators have slipped quietly below the radar.

Canary Wharf in london. One or two analysts have pricked up their ears, but the significance of what may be happening does not seem to have fully registered. Financial regulation is becoming the new frontline in the battle for UK economic growth.

One or two analysts have pricked up their ears, but the significance of what may be happening does not seem to have fully registered. Financial regulation is becoming the new frontline in the battle for UK economic growth.

The shift has been subtle. Last month, the Bank of England’s Financial Policy Committee (FPC) – whose remit is to preserve financial stability and drive economic growth – told the banks that they needed to mark their loans “more prudently” and seek “opportunities to raise capital externally”.

A few days later, Andy Haldane, the Bank’s executive director for financial stability and a member of the FPC, went one step further, arguing that “there is a strong case for regulators stepping in to lessen the uncertainties over valuations”.

The alarming prospect of the regulator telling a bank what to value its assets at, and possibly how much capital it should raise, is becoming a real possibility. The subject will be discussed by the FPC in November “to determine whether additional steps were required”, the latest minutes said.

John-Paul Crutchley, a banks analyst at UBS, spotted the “profound change” in tone and slashed his target price for UK banks by 10pc in response, despite insisting that “we do not believe that any of the UK banks need equity”. Comparing UK banks with those on the continent would suggest he is right. So, why is the FPC threatening to intervene?

The answer is UK economic growth. On June 14, the Chancellor changed the FPC’s mandate from a single focus on financial stability to a dual focus on stability and growth. It was perhaps no coincidence that the announcement was made alongside the Funding for Lending Scheme to get banks lending more to households and businesses at lower rates. The FLS is an undisguised tool in the policy armoury.

But what has growth got to do with bank regulation? It goes back to banks’ asset valuations, as well as their legions of struggling customers. UK banks are potentially holding vast hidden losses on their books, which goes some way to explaining why share prices imply they are worth as little as half their book value.

PIRC, the corporate governance group, has estimated that the banks have £40bn of hidden losses on their books. Although the banks fiercely dispute the number, they do accept that accounting rules prohibit them from taking all their potential bad debts in one go. That they are hiding some losses seems certain.

Forbearance, the practice of giving struggling borrowers easier terms on a temporary basis, has played a large role in protecting both borrowers and banks’ balance sheets in the crisis. The Bank of England has estimated that as much as 8pc of UK mortgages are in forbearance, equivalent to about £100bn of debt. On commercial real estate loans, it reckons a third are in forbearance – or roughly £75bn. In other words, banks are more at risk than they claim to be on £175bn of UK debt.

Take Royal Bank of Scotland as an example. Its most recent figures provided some detail on mortgage forbearance.

The bank disclosed that £7.1bn of its retail book is in some form of forbearance, with borrowers moved on to interest-only mortgages or other, more lenient terms. The provisions against those potential bad debts are minimal. Were they to be treated exactly that same as the smaller book of recognised delinquent loans, RBS would have to set aside an extra £1bn – although, admittedly, this overstates the point. Moreover, RBS has £6.1bn of mortgages that are in negative equity.

Barclays tells a similar story. It has taken provisions of just £12.8m on £1.6bn of loans that are in forbearance. Another £1.6bn of interest-only mortgages have had their terms extended, no doubt because the borrowers could not afford to remortgage. Barclays classes those as fully “performing”.

Lloyds Banking Group would potentially have the largest forbearance levels of all but it has not broken the figures out to date.

Even if PIRC is wrong, it is clear that banks are hiding billions of pounds of potential losses – and that is before their eurozone exposures, which do happen to be quite prudently provisioned. The problem is that the hidden losses have reduced banks’ appetite for more risk, as well as making investors nervous.

The Bank of England may have given banks access to cheap funding and lowered regulations on capital ratios and liquidity requirements, but as long as lenders have a smouldering keg of dynamite on their balance sheets they are not going to volunteer for more risk by lowering lending standards and loading up on debt.

Hence the regulators’ desire to make banks own up and declare their potential losses. There is only one – enormous – problem, though. Taking the hit would wipe out so much capital the banks would need to go back to shareholders, or the taxpayer, cap-in-hand. Which, perhaps, explains why regulators are telling the banks to raise capital now.

As Mr Crutchley warned: “We believe the FPC is now operationalising its views via the FSA. That is, the demands for more equity by the FPC are not new, but the market was rather ignoring them as nothing had happened for so many months. Translating rhetoric into action now seems significantly more likely.”

There is another angle in this for the UK growth strategy. Ask any economist for the main reason the economy is struggling, and they will invariably answer that it’s because there is no consumer demand. Households have had the last pennies squeezed from their pockets and are living in fear of their debts.

Despite suffering nearly three years of falling real disposable income, savings rates have been rising as families pay off their debts, leaving even less to spend in the shops. The household savings ratio, at around 6.5pc, is at a level not seen since before the turn of the millennium.

Household debt is the last frontier for domestic economic policy. So far, borrowers have been helped by the Bank’s decision to slash rates to a record low – but it has just bought time.

According to Oriel Securities, even with record low rates, households are spending 17.7pc of their disposable income on mortgage costs, on average. A decade ago, when the stock of mortgage debt was half as large, mortgage costs ate through just 14.2pc of disposable income. History suggests that if the ratio edges above 20pc, it will become unsustainable.

The are three solutions, Oriel chief economist Darren Winder says. To reduce the stock of debt, to reduce mortgage rates still further, or to raise disposable incomes. Forbearance has addressed mortgage rates, by easing borrowers’ terms, and the FLS is intended to help further, but the stock of debt is largely unchanged and inflation continues to eat away at disposable incomes.

With little room to move on rates or income, the real, longer-term solution, a growing body of economists reckon, is some form of debt forgiveness – wiping out a portion of a borrowers’ obligations permanently.

More recently the US has been operating a small programme of debt forgiveness since the crisis of 2008. Paul Krugman, the economics nobel laureate, has called on the Obama administration to go much further. “Yes, that would in a way be rewarding debtors for their past excesses,” he says. “But economics is not a morality play.”

Politically, debt forgiveness is a non-starter – particularly in the UK under a Conservative-led government. But, economically, it has much to offer. Not least because a purging of household debt would allow the Bank to raise rates without triggering another recession, thereby finally releasing savers from their low-income purgatory.

The lessons from Japan are acute, too. To stimulate growth, Japan tried quantitative easing, infrastructure spending, and credit easing (a version of the FLS). UK policy has been a virtual carbon copy. The difference has been the speed of decision making and the early recapitalisation of the banks.

What Japan never addressed was the necessary debt restructuring. Instead it let “zombie companies [be] supported by zombie banks”, as Bank of Japan deputy governor Kiyohiko Nishimura put it in a recent speech. In the UK, to use a term coined by Fathom Consulting, the problem is “zombie households”.

The rapid build-up of mortgage debt in the 10 years between 2001 and 2011 is visceral proof. In just a decade, UK mortgage debt more than doubled from £591bn to £1.24 trillion.

Where the politicians fear to tread, though, the FPC might. If banks are made to write-off swathes of their forborne mortgages, the improved terms for those borrowers with £100bn of forborne debt could be made permanent. Although the homeowner would still in theory have the same principal loan to repay, the cost of servicing it would be lower – thereby reducing the overall cost. It would be debt forgiveness in another guise. And extrapolating from RBS’s forborne book, as much as £15bn could be forgiven forever.

With the debt burden eased, some of the most hard-pressed households could feel confident enough to start spending in the real economy again.

The big question would be how to recapitalise the banks, though. The FPC has said it will tolerate lower capital ratios, but it wants banks to build up capital levels – seemingly prefiguring a strategy of accommodating both more lending and more losses. It has suggested share issues as well as more innovative ideas, such as “contingent capital” and “liability management exercises”.

It is not an insurmountable request. In Europe, 27 lenders that were instructed to raise capital managed to secure £93bn in just 10 months – about £3.5bn each. And Britain’s banks are a much better investment proposition. However, banks, who fear that the regulator is already becoming too interventionist, would bitterly resist the proposal.

“You’d be asking shareholders to subsidise the economy,” one top banker said, acknowledging the risk of just such a regulatory move. Boardrooms would find that very hard to square with their fiduciary duties.

If financial regulation is to be used as a new growth policy, though, it would not come a moment too soon. Paralysed by the scale of public debt, the Government can not afford any substantial stimulus programmes. At the same time, quantitative easing is losing its “bite”, the Bank’s own deputy governor Paul Tucker has admitted.

Cleansing banks’ balance sheets to free them of their legacy risks, while simultaneously taking some pressure off household finances would potentially address both the supply and demand sides of the economy in one go, and give the recovery the kind of shove it so urgently needs.